Elasticities, Price Distorting Policies and Non-Price Rationing

S O L U T I O N S
18
Elasticities, Price Distorting Policies and
Non-Price Rationing
Solutions for Microeconomics: An Intuitive

Approach
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387 Elasticities, Price Distorting Policies and Non-Price Rationing
18.1 Consider, as we did in much of the chapter, a downward sloping linear demand curve.
In what follows, we will consider what happens to the price elasticity of demand as we approach the
horizontal and vertical axes along the demand curve.
(a) Begin by drawing such a demand curve with constant (negative) slope. Then pick the point A on
the demand curve that lies roughly three quarters of the way down the demand curve. Illustrate
the price and quantity demanded at that point.
Answer: This is depicted in panel (a) of Graph 18.1
Graph 18.1: Price Elasticity as we Approach the Axes
(b) Next, suppose the price drops by half and illustrate the point B on the demand curve for that
lower price level. Is the percentage change in quantity from A to B greater or smaller than the
absolute value of the percentage change in price?
Answer: Since the price drops by half, we know that the absolute value of the percentage change
in price is 50%. It should be obvious from the graph that the percentage increase in quantity
from A to B is smaller than 50% — because the starting quantity at A is large relative to the
change in quantity from A to B .
(c) Next, drop the price by half again and illustrate the point C on the demand curve for that new
(lower) price. The percentage change in price from B to C is the same as it was from A to B . Is the
same true for the percentage change in quantity?
Answer: Since we again halved the price, the percentage change in price is 50%. The percentage
change in quantity from B to C , however, is now smaller than it was from A to B — because
the starting quantity at B is higher than it was at A while the absolute change from B to C is
smaller. For the same percentage change in price, we therefore get smaller percentage changes
in quantity as we move down the demand curve.
(d) What do your answers imply about what is happening to the price elasticity of demand as we
move down the demand curve?
Answer: Price elasticity of demand is the percentage change in quantity over the percentage
change in price. We have held the percentage change in price constant as we moved from A to
B and then from B to C — implying the denominator of the price elasticity formula was kept
the same. But we concluded that the percentage change in quantity (for the same percentage
change in price) is less when we move from B to C than when we moved from A to B — implying
that the absolute value of price elasticity gets smaller as we move down the demand curve.
(e) Can you see what will happen to the price elasticity of demand as we get closer and closer to the
horizontal axis?
Elasticities, Price Distorting Policies and Non-Price Rationing 388
Answer: If you imagine repeating what we have done again — i.e. cutting price by half and
checking what happens to the percentage change in quantity, we will keep getting the same re-
sult: The percentage change in quantity for the same percentage change in price will get smaller
and smaller. Thus, the numerator of the price elasticity formula gets smaller and smaller while
the denominator stays the same — implying that the fraction that represents price elasticity
gets smaller and smaller — and closer and closer to zero — as we move toward the endpoint of
the linear demand curve.
(f) Next, start at a point A ′ on the demand curve that lies only a quarter of the way down the demand
curve. Illustrate the price and quantity demanded at that point. Then choose a point B ′ that has
only half the consumption level as at A ′ . Is the percentage change in price from A ′ to B ′ greater
or less than the absolute value of the percentage change in quantity?
Answer: This is illustrated in panel (b) of Graph 18.1. In moving from A ′ to B ′ , we know that
quantity drops by half — i.e. changes by 50%. But it should be obvious from the graph that price
increases by less than 50%. This is because the beginning price at A ′ is already relatively high
— and the incremental change in price from A ′ to B ′ is relatively low compared to its starting
point.
(g) Now pick the point C ′ (on the demand curve) where the quantity demanded is half what it was
at B ′ . The percentage change in quantity from A ′ to B ′ is then the same as the percentage change
from B ′ to C ′ . Is the same true of the percentage change in price?
Answer: The percentage change is the same because we again dropped quantity by 50%. But
the percentage change in price is now less as we go from B ′ to C ′ than it was when we went
from A ′ to B ′ . This is because the starting price is higher at B ′ than it was at A ′ while the
incremental increase in price from B ′ to C ′ is less than it was from A ′ to B ′ . Thus, as we move
up the demand curve, the percentage change in price gets smaller and smaller (for the same
percentage decrease in quantity).
(h) What do your answers imply about the price elasticity of demand as we move up the demand
curve? What happens to the price elasticity as we keep repeating what we have done and get
closer and closer to the vertical intercept?
Answer: We have shown that, for the same percentage decrease in quantity, the percentage
increase in price gets smaller as we move up the demand curve. Price elasticity of demand is
the percentage change in quantity divided by the percentage change in price. We have held the
percentage change in quantity fixed — i.e. we have held the numerator of the price elasticity
formula fixed; but we have concluded that the denominator becomes smaller as we move up
the demand curve. This implies that we are dividing the same number by smaller and smaller
numbers — which means the overall fraction is increasing in absolute value. The price elasticity
of demand therefore gets larger and larger in absolute value as we move up the demand curve
— and gets closer and closer to (negative) infinity as we get closer to the vertical intercept.
18.2 In this exercise, we explore the concept of elasticity in contexts other than own-price elasticity of
(uncompensated) demand. (In cases where it matters, assume that there are only two goods).
For each of the following, indicate whether the statement is true or false and explain your answer:
(a) The income elasticity of demand for goods is negative only for Giffen goods.
Answer: This is false. The income elasticity of demand is positive for normal goods (because the
quantity demanded increases as income increases for normal goods) and negative for inferior
goods (because quantity decreases as income increases for inferior goods). Thus, although it
is true that the income elasticity of demand is negative for Giffen goods, Giffen goods are not
the only goods for which this is true. In particular, inferior goods that are not Giffen goods (i.e.
“regular inferior goods”) also have negative income elasticities of demand.
(b) If tastes are homothetic, the income elasticity of demand must be positive.
Answer: This is true — because homothetic tastes are tastes for normal goods, and all normal
goods have the property that quantity demanded increases as income increases — thus giving
rise to positive income elasticity of demand.
(c) If tastes are quasilinear in x, the income elasticity of demand for x is zero.
Answer: This is also true. Quasilinear goods don’t give rise to income effects — thus, if income
goes up, quantity demanded remains unchanged. Thus, the percentage change in quantity
over the percentage change in income is zero.
(d) If tastes are quasilinear in x 1 , then the cross-price elasticity of demand for x 1 is positive.
Answer: This is true. If x 1 is quasilinear, then there are no income effects relative to x 1 and
only substitution effects. If p 2 increases, this then implies that the consumer will consume
less of what has become more expensive (x 2 ) and more of what has become relatively cheaper
(x 1 ). Thus, the price of x 2 moves in the same direction as the consumption quantity of x 1 —
implying a positive relationship between the two, and therefore a positive cross-price elasticity
of demand for x 1 .
(e) If tastes are homothetic, cross price elasticities must be positive.
Answer: This is false. Suppose, for instance, that two goods are perfect complements — which
implies tastes are homothetic. Then as p 2 increases, consumption of x 1 falls (since the two
goods have to be consumed together). Thus, we have identified a case of homothetic tastes
for which p 2 and consumption of x 1 move in opposite direction — implying a negative cross
price elasticity of demand. Of course, if the two goods are sufficiently substitutable, the reverse
will be true — as p 2 increases, consumption of x 1 will increase — implying a positive cross-
price elasticity of demand. Thus, for homothetic tastes, the sign of the cross-price elasticity of
demand will depend on the degree of substitutability between the goods.
(f) The price elasticity of compensated demand is always negative.
Answer: Compensated demand curves — or what we also called marginal willingness to pay
curves — incorporate only substitution (and not income) effects and are thus always down-
ward sloping. Thus, the price elasticity of compensated demand is always negative — and the
statement is true.
(g) The more substitutable two goods are for one another, the greater the price elasticity of compen-
sated demand is in absolute value.
Answer: The more substitutable two goods are, the greater the substitution effect that is incor-
porated in compensated demand curves — i.e. the shallower, or more elastic, the compensated
demand curves are. The statement is therefore true. Put differently, the more substitutable
goods are, the greater will be the responsiveness to price if we compensate the consumer to
reach the same indifference curve as before.
18.3 In the labor market, we can also talk about responsiveness — or elasticity — with respect to wages
(and other prices) on both the demand and supply sides.
For each of the following statements, indicate whether you think the statement is true or false (and why):
(a) The wage elasticity of labor supply must be positive if leisure and consumption are normal goods.
Answer: This is false. As wages change, there are off-setting substitution and wealth effects
relative to leisure when leisure is a normal good. This implies that the impact of a change in
wage on labor supply is ambiguous when leisure is normal — and the relationship between
wage and the quantity of labor supplied may be positive or negative (which further implies
that this elasticity may be positive or negative.)
(b) In end-of-chapter exercise 9.5, we indicated that labor supply curves are often “backward-bending”.
In such cases, the wage elasticity of labor supply is positive at low wages and negative at high
wages.
Answer: This is true. The backward bending labor supply that labor economists have identi-
fied as empirically important is upward sloping for low wages and downward sloping for high
wages — implying a positive relationship (and thus a positive wage elasticity) between wage
and quantity of labor supplied at low wages and a negative relationship at high wages.
(c) The wage elasticity of labor demand is always negative.
Answer: This is true — as we illustrated in our treatment of firms, labor demand is always
downward sloping — which implies a negative relationship between wage and the quantity of
labor demanded (and thus a negative wage elasticity of labor demand).
(d) In absolute value, the wage elasticity of labor demand is at least as large in the long run as it is
in the short run.
Answer: This is also true. In Chapter 13, we showed that labor demand curves are shallower
in the long run than in the short run — except for one special case where they have the same
slope. Thus, labor demand is more responsive — or more elastic — in the long run than in the
short run, implying a higher wage elasticity in absolute value.
(e) (The compensated labor supply curve, which we will cover more explicitly in Chapter 19, is the
labor supply curve that would emerge if we always insured you reached the same indifference
curve regardless of the wage rate.) The wage elasticity of compensated labor supply must always
be negative.
Answer: This is false. Compensated labor supply curves only incorporate substitution effects
(and not wealth effects). The substitution effect is unambiguous — if wage increases, leisure
becomes relatively more expensive and is thus consumed in smaller amounts (absent wealth
effects). This implies that, as wage increases, the compensated labor supply also increases —
i.e. the relationship between wage and compensated labor supply is positive. Thus, the wage
elasticity of compensated labor supply is positive.
(f) The (long run) rental rate (of capital) elasticity of labor demand (which is a cross-price elasticity)
is always positive.
Answer: This is false. We showed in Chapter 13 that the relationship between the rental rate of
capital and the quantity of labor demanded may be positive or negative depending on whether
labor and capital are relatively substitutable or relatively complementary in production. Thus,
the elasticity may be positive or negative.
(g) The output price elasticity of labor demand is positive and increases from the short to the long
run.
Answer: This is partly true and partly false. As output price increases, firms want to produce
more and thus hire more of all inputs — including labor. Thus, the relationship between output
price and the quantity of labor demanded is positive, both in the short and long run. But we
showed in Chapter 13 that such responses may be larger or smaller in in the long run than in
the short run depending again on the degree of substitutability of labor and capital. (It may be
that the firm will hire more labor in the short run but in the long run lets some labor go and
substitutes into capital instead.)
18.4 In this exercise, treat the real interest rate r as identical to the the rental rate on capital.
We will now consider the responsiveness — or elasticity — of savings and borrowing behavior with
respect to changes in the interest rate (and other prices). Suppose that tastes over consumption now and
in the future are homothetic, and further suppose that production frontiers (that use labor and capital
as inputs) are homothetic.
(a) Can you tell whether the interest rate elasticity of savings (or capital supply) is positive or negative
for someone who earns income now but not in the future?
Answer: When tastes over consumption now and in the future are homothetic and all income
is earned now (rather than in the future), we have offsetting wealth and substitution effects on
consumption now as the interest rate changes. In particular, an increase in the interest rate
causes consumption now to become relatively more expensive — implying a substitution ef-
fect that suggests less consumption now, and thus more savings. At the same time, an increase
in the interest rate causes real wealth to increase — implying a wealth effect that suggests more
consumption now, and thus less savings. Whether the relationship between the interest rate
and savings is positive or negative then depends on the degree of substitutability of consump-
tion across time — and thus we cannot generally say whether the interest rate elasticity of sav-
ings (or capital supply) for someone who earns all income now is positive or negative.
(b) Can you tell whether the interest rate elasticity of borrowing (or capital demand) is positive or
negative for someone who earns no income now but will earn income in the future?
Answer: For someone who earns all income in the future, an increase in the interest rate results
in an increase of the relative price of consuming now as well as a decrease in real wealth. As
a result, the substitution effect tells us that an increase in the interest rate for this person will
cause him to consume less now — and thus borrow less, and the wealth effect will similarly
tell us that this person will consume less now (and in the future) — and thus will again borrow
less. Since both effects point in the same direction, there is no ambiguity — an increase in the
interest rate causes a decrease in borrowing. The interest rate elasticity of borrowing (or capital
demand) is therefore negative.
(c) Is the interest rate elasticity of demand for capital by firms positive or negative?
Answer: Input demand curves for firms always slope down — which implies that the quantity
of capital demanded by firms declines as the interest rate increases. The interest rate elasticity
of capital demand by firms is therefore negative.
(d) Is the wage elasticity of demand for capital by firms positive or negative?
Answer: We showed in Chapter 13 that the direction of the demand response for capital from
a change in the wage rate depends on the degree of substitutability of capital and labor in pro-
duction. If capital and labor are highly substitutable, then an increase in the wage rate can
result in an increased demand for capital (even though the firm produces less output); but if
labor and capital are relatively complementary, then an increase in the wage rate will result in
a decrease of capital demanded. Thus, the wage elasticity of capital demand by firms may be
positive or negative.
(e) Is the output price elasticity of demand for capital positive or negative?
Answer: As output price increases, firms will produce more and hire more inputs. Thus, as
price increases, capital demanded increases — which implies that the output price elasticity of
capital demand by firms is positive.
18.5 In our treatment of price floors, we illustrated the case of a government program that purchases any
surplus produced in the market. Now consider a price ceiling — and the analogous case of the government
addressing disequilibrium shortages through purchases on international markets.
Suppose, for instance, that the U.S. demand and supply curves for coffee intersect at p ∗ which is also
the world price of coffee.
(a) Suppose that the government imposes a price ceiling p c below p ∗ for domestic coffee sales. Illus-
trate the disequilibrium shortage that would emerge in the domestic coffee market.
Answer: This is illustrated in panel (a) of Graph 18.2.
Graph 18.2: Coffee Price Ceiling
(b) In the absence of any further interference in the market, what would you expect to happen?
Answer: Consumers would have to compete for the quantity x s — expending effort that, in
equilibrium, will equal the bold vertical distance in panel (a) of Graph 18.2. Thus, the effective
price consumers will end up paying (including their effort cost) is p ′ .
(c) Next, suppose that, as part of the price ceiling policy, the government purchases coffee in the
world market (at the world market price p ∗ ) and then sells this coffee at p c domestically to any
consumer that is unable to purchase coffee from a domestic produce. What changes in your
analysis?
Answer: Now consumers no longer have to compete with each other for the limited amount of
coffee supplied domestically at the price ceiling — because the government supplies anything
that domestic producers do not supply. Thus, consumers will actually only have to pay the
price ceiling p c (rather than p ′ ).
(d) Illustrate — in a graph with the domestic demand and supply curves for coffee — the deadweight
loss from this government program (assuming that your demand curve is a good approximation
of marginal willingness to pay).
Answer: This is illustrated in panel (b) of Graph 18.2. Consumers now get surplus (a + b + c +
d + e + f ) while domestic producers get surplus (h). The government has to buy the difference
between x d and x s at the world market price p ∗ — and then sells this quantity at p c . Thus, the
government loses (p ∗ −p c ) on the quantity (x d −x s ). This is equal to area (e + f +g ). Adding up
producer and consumer surplus — and subtracting the net cost of the government program, we
then get overall surplus of (a + b + c + d + h − g ). Were these programs not in existence, overall
surplus would be (a + b + c + d + e + h). Thus, we lose (e + g ) as a result of this government
program — i.e. the deadweight loss is (e + g ).
18.6 Everyday Application: Scalping College Basketball Tickets: At many universities, college basketball
is intensely popular and, were tickets sold at market prices, many students who wish to attend games
would not be able to afford to do so. As a result, universities have come up with non-price rationing
mechanisms to allocate basketball tickets.
Suppose throughout this exercise that demand curves are equal to marginal willingness to pay curves
and no one would ever pay more than $250 for a basketball ticket.
(a) First, suppose only students care about basketball. Draw a demand and supply curve for basket-
ball tickets (to one game) assuming the stadium capacity is 5,000 seats and assuming that supply
and (student) demand intersect at $100.
Graph 18.3: Basketball Tickets
(b) Suppose students have an opportunity cost of time equal to $20 per hour. The university gives
away tickets to the game for free to anyone with a valid student ID, but only the first 5,000 stu-
dents who line up will get a ticket. In equilibrium, how long will the line for basketball tickets
be; i.e. how long will students have to wait in line to get a ticket?
Answer: Since the equilibrium price is $100 and students value their time at $20, the equilib-
rium line length must be 5 hours.
(c) What is the deadweight loss from the free ticket policy in (b)? (You can show this on your graph
as well as arrive at a dollar figure).
Answer: The deadweight loss DW L is indicated in panel (a) of the graph. It is equal to the value
of time spent by students standing in line — which is a cost for students but of no benefit to
anyone else. The dollar value is 5,000(100) = $500,000.
(d) Now suppose that faculty care about basketball every bit as much as students. Unlike students,
however, faculty have an opportunity cost of time equal to $100 per hour. Will any faculty attend
basketball games under the policy in (b) (assuming students are not allowed to sell tickets to the
faculty)?
Answer: With just students lining up, the line is 5 hours long. Faculty value their time at $100
per hour — and the problem states that no one is willing to spend more than $250 for a ticket. A
5 hour line costs $500 for faculty — which is more than any of them are willing to pay to attend
a game. Thus, no faculty would line up, and no faculty would attend the game.
(e) Now suppose anyone can sell, or “scalp”, his ticket at any price if he obtained one standing in line.
Draw a new supply and demand graph — but this time let this be the market for tickets after the
university has allocated them using their zero price/waiting-in-line policy. The suppliers are
therefore those who have obtained tickets by standing in line, and the supply curve is determined
by the willingness of those people to sell their tickets. What would this supply curve look like?
Who would be the demanders?
Answer: This is illustrated in panel (b) of Graph 18.3. The supply curve is composed of the 5,000
students who got tickets in panel (a) — and who value them between $100 and $250 dollars.
The demand curve is the demand for tickets by faculty. These will intersect at some price p ∗
between $100 and $250 — with x ∗ tickets sold to faculty and the remaining (5,000 − x ∗ ) tickets
remaining with students.
(f) A market such as the one you have just illustrated is called a secondary market — i.e. a market
where previous buyers now become sellers. The common policy (often enshrined into law) of
not permitting “scalping” of tickets is equivalent to setting a price ceiling of zero in this market.
Under this policy, how many tickets will be sold in the secondary market?
Answer: A price ceiling of zero will result in no tickets being sold in the secondary market. (The
real price ceiling imposed by no-scalping laws is often the “face value” of the ticket — which
would usually be below a value that facilitates many sales. In our example, no sales will happen
in the secondary market so long as the face value is below $100 per ticket.)
(g) How much surplus is being lost through the “no scalping” policy? Is anyone made worse off by
allowing scalping of tickets?
Answer: The no scalping policy results in a loss of surplus equal to a plus b in panel (b) of Graph
18.3. The a portion is surplus lost by faculty who are kept from going to the game, and the b
portion is surplus lost by students who would prefer to sell their ticket to a faculty member at
price p ∗ rather than go to the game. High demanding faculty and low demanding students
would be better off if scalping would be allowed — and no one else would be affected. Thus, no
one would be made worse off by allowing scalping, and some people would be made better off.
(h) In the absence of this policy, how would the mix of people attending the game change?
Answer: With the no-scalping policy, only students attend the games. Without the no-scalping
policy, both faculty and students will attend the games.
18.7 Business and Policy Application: Minimum Wage Laws: Most developed countries prohibit employ-
ers from paying wages below some minimum level w. This is an example of a price floor in the labor mar-
ket — and the policy has an impact in a labor market so long as w > w ∗ (where w ∗ is the equilibrium
wage in the absence of policy-induced wage distortions.)
Suppose w is indeed set above w ∗ , and suppose that labor supply slopes up.
(a) Illustrate this labor market — and the impact of the minimum wage law on employment.
Answer: This is illustrated in panel (a) of Graph 18.4 where ℓ∗ is the pre-minimum wage level
of employment and ℓ A is the post-minimum wage level of employment. Thus, employment
falls by (ℓ∗ − ℓ A ).
Graph 18.4: Minimum Wage Laws
(b) Suppose that the disequilibrium unemployment caused by the minimum wage gives rise to more
intense effort on the part of workers to find employment. Can you illustrate in your graph the
equilibrium cost of the additional effort workers expend in securing employment?
Answer: The disequilibrium unemployment is the difference between ℓB and ℓ A in panel (a)
of Graph 18.4. If this disequilibrium is resolved by workers competing more intensely for jobs,
then workers will require a higher wage in order to cover these additional costs. Thus, the
labor supply curve shifts up as workers incur additional costs and point A does not become an
equilibrium until the labor supply curve has shifted up by (w − w ′ ) which is the equilibrium
increase in effort costs on the part of workers.
(c) If leisure were quasilinear (and you could therefore measure worker surplus on the labor supply
curve), what’s the largest that deadweight loss from the minimum wage might become?
Answer: The largest possible deadweight loss is composed of two parts (both represented in
panel (a) of Graph 18.4): First, there is a deadweight loss from the decrease in employment
(from ℓ∗ to ℓ A ). This deadweight loss is equal to area (c + d ). The second part of deadweight
loss emerges from the increased effort costs of workers to secure employment. These costs sum
to (a +b) — and how much of this is deadweight loss depends on how much of it is recouped by
someone else in the economy. If none of it is recouped by anyone else (as when workers simply
run from place to place applying frantically for jobs), the entire area is deadweight loss. Thus
the largest possible area of deadweight loss is (a + b + c + d ).
(d) How is the decrease in employment caused by the minimum wage (relative to the non-minimum
wage employment level) related to the wage elasticity of labor demand? How is it related to the
wage elasticity of labor supply?
Answer: The more inelastic the demand curve, the smaller the distance between ℓ∗ and ℓ A
— i.e. the smaller the impact of the minimum wage law on employment. The elasticity of the
supply curve plays no role in determining ℓ A — the post-minimum wage employment level —
and therefore is not relevant for determining the employment impact of the minimum wage
law. This can be seen in panels (b) and (c) of Graph 18.4. In panel (b), the demand curve
D is more inelastic than the demand curve D ′ — with the former leading to a reduction in
′
employment from ℓ∗ to ℓ A and the latter leading to a larger reduction from ℓ∗ to ℓ A . In panel
(c), the supply curve S ′ is more elastic than the curve S — but for both, the new equilibrium
moves to A which is unaffected by the elasticity of the supply curve.
(e) Define unemployment as the difference between the number of people willing to work at a given
wage and the number of people who can find work at that wage. How is the size of unemployment
at the minimum wage affected by the wage elasticities of labor supply and demand?
Answer: This definition if unemployment is the difference between ℓB and ℓ A in panel (a) of
the graph. In panels (b) and (c), it is obvious that greater elasticity of demand or supply will
widen the gap between ℓ A — the number of workers that can work under the minimum wage,
and ℓB — the number of workers who would like to work at the minimum wage. When la-
bor demand curves get more wage elastic, the increase unemployment therefore comes from a
larger reduction in actual employment; and when the labor supply curve becomes more elastic,
the increase in unemployment comes from an increase in the number of workers that would
like to work at the higher wage.
(f) How is the equilibrium cost of effort exerted by workers to secure employment affected by the
wage elasticities of labor demand and supply?
Answer: Again, we can read the answers off the graphs in panels (b) and (c) of Graph 18.4. In
panel (b), demand becomes more elastic from D to D ′ — leading to an increase in the equilib-
′
rium effort cost from (w − w A ) to (w − w A ). In panel (c), on the other hand, the supply curve
becomes more elastic from S to S ′ — this time leading to a decrease in the effort cost from
′
(w − w B ) to (w − w B ). An increase in the wage elasticity of labor therefore leads to an increase
in the effort cost — while an increase in the elasticity of supply leads to a decrease in that cost.
18.8 Business and Policy Application: Usury Laws: The practice of charging interest on money that is
lent by one party to another, while commonplace now, has been historically controversial. Major religions
have prohibited the charging of interest in the past (and some do so today), and governments have often
codified this moral objection to interest in what is known as usury laws that limit the amount of interest
that individuals can charge one another.
Usury laws are thus simply an example of a price ceiling in the market for financial capital.
(a) Illustrate a demand and upward sloping supply curve in the market for financial capital (with
the interest rate on the vertical axis). Denote the equilibrium interest rate in the absence of dis-
tortions as r ∗ .
Answer: This is done in panel (a) of Graph 18.5.
Graph 18.5: Usury Laws and Elasticities
(b) If usury laws prohibit interest rates above r ∗ , will they have any impact?
Answer: No, they would not. If the price ceiling is set above the equilibrium price, then the
equilibrium price is in fact legal — and thus will emerge in the market.
(c) Suppose the highest legal interest rate r is set below r ∗ . Explain what will happen to the amount
of financial capital provided by suppliers of such capital.
Answer: This is also illustrated in panel (a) of Graph 18.5 where the amount of financial capital
transacted in the market falls from k ∗ to kS as a result of the usury law.
(d) In light of the fact that financial capital is essential for an economy to grow, what would you
predict will happen to economic growth as a result of such a usury law?
Answer: Since the usury law reduces the amount of financial capital available, a number of
projects will not take place in the economy and economic growth will suffer.
(e) How is the decrease in financial capital from usury laws related to the interest rate elasticity of
demand? How is it related to the interest rate elasticity of supply?
Answer: This is treated in panels (b) and (c) of Graph 18.5. In panel (b), the interest rate elastic-
ity of demand increases (in absolute value) from D ′ to D ′′ — i.e. demand becomes more elastic.
Since the amount of financial capital that is transacted under the usury law is determined by
the supply (and not the demand) curve, kS is the same for both demand curves and is therefore
unaffected by the interest rate elasticity of demand. In panel (c), the interest rate elasticity of
supply increases from S ′ to S ′′ — and as the supply curve becomes more elastic, the drop in
financial capital increases from the initial drop to kS′ to kS′′ . Thus, as the interest rate elasticity
of supply increases, the impact of usury laws on financial capital increases.
(f) Consider how a new equilibrium is likely to be reached in the financial market after the imposi-
tion of such a usury law. In addition to the dampening effect of less capital on economic growth,
can you think of another related factor that may dampen such growth?
Answer: When usury laws interfere with the price signal that rations financial capital, some
other mechanism has to ration the lower amount of financial capital in the market. The most
natural assumption is that investors will now have to expend greater effort in securing financial
capital for their projects — with the equilibrium effort level per unit of capital equal to (r ′ − r )
in panel (a) of Graph 18.5. Such effort could have gone into more productive uses and may
therefore further dampen economic growth.
(g) How is this factor (relating to the effort expended on securing financial capital) affected by the
interest rate elasticity of demand and supply?
Answer: This is again treated in panels (b) and (c) of Graph 18.5. In panel (b), the demand curve
becomes more elastic from D ′ to D ′′ — and with it the per unit equilibrium effort cost falls from
(r ′ −r ) to (r ′′ −r ). Thus, the more elastic the demand curve, the less effort will have to be exerted
by investors to get to the reduced level of capital. In panel (c), the supply curve becomes more
elastic from S ′ to S ′′ — and the effort cost nowincreases from (r ′ − r ) to (r ′′ − r ). Thus, the per
unit effort cost of getting to the reduced level of capital increases with the elasticity of supply.
18.9 Business and Policy Application: Subsidizing Corn through Price Floors: Suppose the domestic de-
mand and supply for corn intersects at p ∗ — and suppose further that p ∗ also happens to be the world
price for corn. (Since the domestic price is equal to the world price, there is no need for this country to
either import or export corn.) Assume throughout that income effects do not play a significant role in the
analysis of the corn market.
Suppose the domestic government imposes a price floor p that is greater than p ∗ and it is able to keep
imports of corn from coming into the country.
(a) Illustrate the disequilibrium shortage or surplus that results from the imposition of this price
floor.
Answer: This is illustrated in panel (a) of Graph 18.6 where domestic supply and demand inter-
sect at p ∗ and the price floor p is imposed above p ∗ . This results in a disequilibrium surplus,
with x S supplied but only x D demanded.
Graph 18.6: Price Floor in Corn Market
(b) In the absence of anything else happening, how will an equilibrium be re-established and what
will happen to producer and consumer surplus?
Answer: Consumer surplus will fall from (a + b + e) to a while producer surplus will fall from
(c + d + f ) to d . This is because, in equilibrium, producers will have to exert additional effort
— i.e. incur additional costs — to compete for the limited number of consumers — which will
cause the effective price they receive to fall to p ′ . (The additional marginal cost of effort on the
part of producers must be (p − p ′ ) in order to make point A in panel (a) of Graph 18.6 the new
equilibrium in which the disequilibrium shortage has been eliminated.)
(c) Next, suppose the government agrees to purchase any corn that domestic producers cannot sell
at the price floor. The government then plans to turn around and sell the corn it purchases on
the world market (where its sales are sufficiently small to not affect the world price of corn). Il-
lustrate how an equilibrium will now be re-established — and determine the change in domestic
consumer and producer surplus from this government program.
Answer: This is illustrated in panel (b) of Graph 18.6 where the difference between x S and x D —
previously labeled a “disequilibrium surplus” in panel (a) — now becomes the quantity of corn
purchased by the government. In essence, the government purchasing program causes the
equilibrium to settle at B rather than A (as in panel (a) of the graph) — because producers no
longer have an incentive to expend addition effort to attract consumers since the government
is guaranteeing it will purchase what cannot be sold at the price floor. Consumer surplus is
then again a (since consumers purchase x D at p as before; producer surplus, however, now
increases to (b + c + d + e + f + g ) as producers supply x S at the price p.
(d) What is the deadweight loss from the price floor with and without the government purchasing
program?
Answer: The greatest possible surplus achievable in this market is (a+b+c +d +e + f ). With just
the price floor (and no government purchasing program), we concluded above that consumer
and producer surplus together will be (a + b + c + d ) — implying a deadweight loss of (e + f ).
When the price floor is supplemented with the government purchasing program, the sum of
consumer and producer surplus becomes (a+b+c+d +e + f +g ). However, we now need to take
into account that the government is also having to spend resources in order to buy the surplus
at the price floor p and then sell it at a loss at p ∗ . It will therefore cost (e + f +g +h +i + j ) to buy
the surplus corn and, when sold at p ∗ , it will raise revenues of ( f +i + j ) — leaving a government
loss of (e + g + h). The total surplus is then the sum of producer and consumer surplus minus
the government loss — which comes to (a +b +c +d +e + f +g )−(e +g +h)=(a +b +c +d + f −h).
Compared to the most possible surplus of (a + b + c + d + e + f ), this implies a deadweight loss
of (e + h).
(e) In implementing the purchasing program, the government notices that it is not very good at get-
ting corn to the world market — and all of it spoils before it can be sold. How does the deadweight
loss from the program change depending on how successful the government is at selling the corn
on the world market?
Answer: The government loss now becomes (e + f + g +h +i + j ) — which gives us total surplus
of (a+b+c+d +e + f +g )−(e + f +g +h+i + j )=(a+b+c+d −h−i − j ). Compared to the maximum
possible surplus of (a + b + c + d + e + f ), this gives us a deadweight loss of (e + f + h + i + j ).
(f) Would either consumers or producers favor the price floor on corn without any additional gov-
ernment programs?
Answer: As illustrated in part (b) of the question, both producers and consumers lose surplus
under the price floor policy without additional government programs. Thus, neither would
favor such a program.
(g) Who would favor the price floor combined with the government purchasing program? Does their
support depend on whether the government succeeds in selling the surplus corn? Why might they
succeed in the political process?
Answer: As illustrated in part (c) of the question, producers gain substantial amounts of surplus
when the government program is added to the price floor — and the amount of surplus they
gain does not depend on what the government does with the surplus corn that was purchased.
Thus, producers would favor the price floor when combined with the government purchasing
program — and they might succeed in the political process because they are a relatively small
group (compared to consumers and tax payers) experiencing concentrated benefits. This gives
them an incentive to expend resources to lobby for such a program — and the diffuse nature
of the costs (spread over many consumers and taxpayers) makes it unlikely that those who lose
from the program will politically organize against it.
(h) How does the deadweight loss from the price floor change with the price elasticity of demand?
Answer: It decreases as demand becomes more inelastic.
18.10 Business and Policy Application: Corn Subsidies through Price Floors (continued): Consider the
same set-up as in exercise 18.9.
Suppose again that a price floor p greater than the equilibrium price p ∗ has been imposed and that the
government has committed to purchase the difference between what is supplied at the price floor and
what is demanded.
(a) If you have not done so in exercise 18.9, illustrate the smallest possible deadweight loss in the
absence of the government purchasing program as well as the deadweight loss if the government
purchases the excess corn and then sells it at the world price p ∗ .
Answer: Using the logic of exercise 18.9, the smallest possible deadweight loss of just the price
floor is (e + f ) in panel (a) of Graph 18.7; and the deadweight loss when the government pur-
chases the excess corn produced and sells it at the world market price is (e + h).
Graph 18.7: Corn Subsidies through Price Floors (cont)
(b) How would the deadweight loss change if the government found a way to give the corn it pur-
chases to those consumers that place the highest value on it.
Answer: In this case, the consumers who purchase corn at the price floor still get consumer sur-
plus equal to area a; and among the remaining consumers, those who value the corn the most
are those whose demand falls on the demand curve just below the price floor. If the govern-
ment purchases (x S − x D ), this implies the consumers on the demand curve between x D and
x S will receive the corn the government gives away — getting consumer surplus of (e + f +k+m)
(since they pay nothing for the corn). Thus, total consumer surplus is now (a + e + f + k + m).
Producers get surplus (b+c +d +e + f +g ) as they sell x S at the price floor p, and the government
incurs a cost of (e + f + g + h + i + k + m). Thus, the total social surplus is
Total Surplus = (a + e + f + k + m) + (b + c + d + e + f + g ) − (e + f + g + h + i + k + m)
= a +b +c +d +e + f −h −i. (18.1)
Given that the maximum social surplus in the absence of price distortions is (a+b+c +d +e + f ),
this implies a deadweight loss of (h + i ).
(c) What happens to the deadweight loss if the government instead sets a price at which all the excess
corn gets sold assuming it can keep those who purchased at the price floor from buying at the
lower government price.
Answer: Consumer surplus still remains a for those who purchase at the price floor. In order
to sell the excess corn, the government would have to set the price p in panel (a) of Graph 18.7
— implying that consumers who did not buy at the price floor will get consumer surplus of
(e + f + k). Adding the two consumer surplus areas together, overall consumer surplus is then
(a+e + f +k). Producer surplus would still be (b+c+d +e + f +g ) as before; but the government’s
cost is now (e + f + g + h + i + k) (and no longer included m because this amount is collected as
the excess corn is sold). Thus, the overall social surplus is
Total Surplus = (a + e + f + k) + (b + c + d + e + f + g ) − (e + f + g + h + i + k)
= a +b +c +d +e + f −h −i. (18.2)
Thus, the deadweight loss is again (h + i ).

(d) Compare your answers to (b) and (c) — they should be the same. Can you explain intuitively why
this is the case?
Answer: The reason the two answers are the same is that, in both cases, the excess corn is con-
sumed by those who value it most. In (b), this is done because the government is somehow
able to magically find the people who value the corn the most and give it to them; in (c), the
government sets the price at which it can sell all the excess corn — and lets that price deter-
mine who gets the corn. If it sets the price correctly, the same consumers will get it as if the
government somehow identified those who value it the most. In (b), the government loses m
in revenue but consumers pick it up as surplus; in (c) the government picks up m in revenue
and the consumers lose it in surplus.
(e) Consider the policy as described in (c). After the initial set of consumers purchase corn at the
price floor, illustrate the demand curve for the remaining consumers — and the supply curve for
corn from the government. What’s the elasticity of supply of government corn — and at what
price must this supply curve cross the demand curve of the consumers who did not buy at the
price floor?
Answer: This is done in panel (b) of Graph 18.7. The demand curve of those who remain after
the initial purchases at the price floor happen, denoted D r , has to begin at p — because anyone
with marginal willingness to pay above p has already bought at the price floor. The rest of the
demand curve then has the same slope as in panel (a) since it is simply the part of the original
demand curve below p. The government supply curve, denoted S g , is perfectly inelastic at the
quantity the government committed to purchase. Supply and demand must intersect at p from
panel (a).
(f) Finally, suppose that everyone (including those with marginal willingness to pay the exceeds the
price floor) wants to buy at the lower government price but the government still agrees to buy any
amount of corn that producers are willing to supply at the price floor. What will happen — and
how will it affect the deadweight loss?
Answer: Now no one except the government buys at the price floor — and all consumers buy
at p. Producer surplus is unchanged at (b + c + d + e + f + g ) (since they are still selling x S to
the government at p.) Since all consumers now purchase at p from the government, consumer
surplus is (a +b +c +d +d +e + f +ℓ+k). And the government now purchases the entire amount
x S at p and sells it at p — implying a government loss of (b + c + d + e + f + g + h + i + ℓ + k).
Total social surplus is then
Social Surplus = (a + b + c + d + d + e + f + ℓ + k) + (b + c + d + e + f + g )
− (b + c + d + e + f + g + h + i + ℓ + k)
= a +b +c +d +e + f −h −i. (18.3)
Given that the maximum surplus under no price distortions is (a + b + c + d + e + f ), the dead-
weight loss is again (h + i ).
(g) Why is your answer again the same as under the previous policies?
Answer: Again, given the quantity x S that is produced under the combination of the price floor
and government purchase guarantee, the corn is allocated to those who value it the most. The
government now incurs a much greater cost than before because it purchases all the corn in-
stead of having some consumers buy at the price floor — but this is exactly offset by additional
consumer surplus. In essence, we can think of this as a two-stage process: In the first stage, the
government buys x S at p from producers — giving rise the producer surplus. It then inelas-
tically supplies x S to consumers — with the government supply therefore vertical at x S . This
implies that demand and government supply cross at p — with those who value the corn the
most purchasing it from the government.
18.11 Policy Application: Rent Control: A portion of the housing market in New York City (and many
other cities in the world) is regulated through a policy known as rent control. In essence, this policy puts a
price ceiling (below the equilibrium price) on the amount of rent that landlords can charge in the apart-
ment buildings affected by the policy.
Assume for simplicity that tastes are quasilinear in housing.
(a) Draw a supply and demand graph with apartments on the horizontal axis and rents (i.e. the
monthly price of apartments) on the vertical. Illustrate the “disequilibrium shortage” that would
emerge when renters believe they can actually rent an apartment at the rent-controlled price.
Graph 18.8: Rent Controlled Apartments
(b) Suppose that the NYC government can easily identify those who get the most surplus from getting
an apartment. In the event of excess demand for apartments, the city then awards the right to live
(at the rent-controlled price) in these apartments to those who get the most consumer surplus.
Illustrate the resulting consumer and producer surplus as well as the deadweight loss from the
policy.
Answer: This is illustrated in panel (a) of Graph 18.8. The area (a + b) would now be consumer
surplus — because these “high demanders” are the ones who get the apartments and only have
to pay the price ceiling. Producer surplus is just area c — and deadweight loss is area d that no
one receives because these apartments are not put on the market under rent control.
(c) Next, suppose NYC cannot easily identify how much consumer surplus any individual gets —
and therefore cannot match people to apartments as in (b). So instead, the mayor develops a
“pay-to-play” system under which only those who pay monthly bribes to the city will get to “play”
in a rent-controlled apartment. Assuming the mayor sets the required bribe at just the right level
to get all apartments rented out, illustrate the size of the monthly bribe.
Answer: This is illustrated as the distance B in panel (a) of Graph 18.8. By charging a bribe of
this size, the mayor is able to collect a bribe from everyone who values these apartments at
least as much as the price ceiling plus B — which is exactly the number of people we can fit
into the rent-controlled apartments that are available.
(d) Will the identity of those who live in rent-controlled apartments be different in (c) than in (b)?
Will consumer or producer surplus be different? What about deadweight loss?
Answer: In both cases, only the high demanders get into the apartments — so the identity
of those living in the apartments is the same under both policies. The producer surplus and
deadweight loss remains similarly the same. But now part of what is consumer surplus in (b)
becomes revenue from bribes in (c); i.e. consumer surplus is (a + b) in (b) but only a in (c) —
because now each consumer has to pay the bribe B on top of the price ceiling. The area b then
becomes the bribe revenue for the mayor. Since this is a pure transfer from consumers to the
mayor, it is not deadweight loss.
(e) Next, suppose that the way rent-controlled apartments are allocated is through a lottery. Who-
ever wants to rent a rent-controlled apartment can enter his/her name in the lottery, and the
mayor picks randomly as many names as there are apartments. Suppose the winners can sell
their right to live in a rent-controlled apartment to anyone who agrees to buy that right at what-
ever price they can agree on. Who do you think will end up living in the rent-controlled apart-
ments (compared to who lived there under the previous policies)?
Answer: When all is said and done, the same people should once again end up in the apart-
ments — whether they won in the lottery or not. This is because they value the apartments the
most. If they win a ticket, they won’t find someone that will buy it for an amount that exceeds
how much they value the apartment. If they don’t win a ticket, they will find someone that does
not value the apartment as much as they do — and will thus buy the right to the apartment.
(f) The winners in the lottery in part (e) in essence become the suppliers of “rights” to rent-controlled
apartments while those that did not win in the lottery become the demanders. Imagine that
selling your right to an apartment means agreeing to give up your right to occupy the apartment
in exchange for a monthly check q. Can you draw a supply and demand graph in this market
for “apartment rights” and relate the equilibrium point to your previous graph of the apartment
market?
Answer: The lottery will have made winners of some that really value the apartments highly
and some that really don’t value it very much at all. Thus, some of the winners will be willing
to sell their rights at relatively low prices while others will demand higher prices. This results
in a supply curve of the form in panel (b) of Graph 18.8 where the supply curve effectively ends
— or becomes vertical — at x s , the number of apartments that were raffled off in the lottery.
The demand curve is made up of those who did not win in the lottery. We can’t tell precisely
what each of these curves will look like because of the randomness of the lottery — but they
will intersect at an equilibrium price that allocates apartments to those who value them most.
That price has to be equal to the size of the bribe B we identified in panel (a) as “clearing the
market” — i.e. in equilibrium, those who get an apartment will again pay the price ceiling plus
B = q∗.
(g) What will be the equilibrium monthly price q ∗ of a “right” to live in one of these apartments
compared to the bribe charged in (c)? What will be the deadweight loss in your original graph of
the apartment market? How does your answer change if lottery winners are not allowed to sell
their rights?
Answer: As already explained in the answer to (f), q ∗ = B . The end result of the lottery com-
bined with the market in “rights” will therefore again be the same as before — output is still
limited to x s , with high demanders living in the apartments. Those high demanders that won
the lottery get a surplus equal to the difference between their marginal willingness to pay and
the price ceiling; those who had to buy a right to an apartment because they did not win in the
lottery only get a surplus of the difference between their MW T P and the rental price inclusive
of q ∗ . And those who won but sold their rights get a surplus q ∗ . Overall, consumers therefore
get surplus a in panel (a) of Graph 18.8, and the sum of all the q ∗ surpluses — whether made by
those who won and chose to live in an apartment or by those who won and sold their rights —
is equal to area b. Landlords still get c — but no one gets d . Thus, d continues to be the dead-
weight loss. If, however, the lottery winners are not allowed to sell their rights, the deadweight
loss will be larger because of the effective price ceiling of zero in the “rights” market where sur-
plus is lost. Put differently, the “wrong” people will live in the apartments — in the sense that
some who value the apartments more would be willing to pay these people an amount at which
they would prefer not to live there and let others move in. The only way that the deadweight
loss would not increase if we prohibit trade in the rights to apartments is if the lottery mag-
ically chose only the high demanders as winners — which would make everything identical
to the case where the mayor magically knew who the high demanders were and allocated the
apartments to them.
(h) Finally, suppose that instead the apartments are allocated by having people wait in line. Who
will get the apartments and what will deadweight loss be now? (Assume that everyone has the
same value of time.)
Answer: The same people will again live in the apartments — but they will now pay the cost B
in the form of waiting in line. Since no one benefits from this, that implies that area b in Graph
18.8 now becomes part of deadweight loss.
18.12 Policy Application: NYC Taxi Cab Medallions: In New York City, you are allowed to operate a taxi
cab only if you carry a special taxi “medallion” made by the Taxi Commission of New York. Suppose 50,000
of these have been sold, and no further ones will be put into circulation by the Taxi Commission. We
will see that restricting supply in this way is another way in which governments can inefficiently distort
price.
Suppose for simplicity that there are no income effects of significance in this problem. We will analyze
the demand and supply of a day’s worth of cab rides — which we will call “daily taxi rides”.
(a) On a graph with daily taxi rides on the horizontal axis and dollars on the vertical, illustrate the
daily aggregate demand curve for NYC taxi rides. Given the fixed supply of medallions, illustrate
the supply curve under the medallion system.
Answer: This is illustrated in Graph 18.9 where the supply curve is perfectly inelastic at 50,000
daily taxi rides because of the limit imposed by the medallion system.
Graph 18.9: Taxi Cab Medallions
(b) Illustrate the daily revenue a cab driver will make. (Since we are denoting quantity in terms of
“daily cab rides”, the price of one unit of the output is equal to the daily revenue.)
Answer: The equilibrium price for a day’s worth of cab rides is then p M as indicated in the
graph. This is the daily revenue collected by a cab driver.
(c) In the absence of the medallion system, taxi cabs would be free to enter and exit the cab business.
Assuming that everyone faces the same cost to operating a cab, what would the long run supply
curve of cabs look like? Illustrate this on your graph under the assumption that removal of the
medallion system would result in an increase in the number of cab rides. Indicate the long run
daily price of a cab and the number of cabs operating in the absence of the medallion system.
Answer: If everyone faces the same cost of operating a cab, then the long run supply curve
should be horizontal at that marginal cost of operating a cab — because new cabs can always
enter and old ones exit as demand shifts. This is illustrated in Graph 18.9 with a flat line that
lies below p M and thus results in more daily cab rides x ∗ sold at the long run competitive price
p∗.
(d) Suppose you own a medallion and you can rent it out to someone else. Indicate in your graph
the equilibrium daily rental fee you could charge for your medallion. How much profit are those
who rent a medallion in order to operate a cab making? Is that different from how much profit
those who own a medallion and use it to operate a cab are making?
Answer: As a cab driver, you make zero profit if you simply make p ∗ per day. Thus, under the
medallion system, your profit is (p M − p ∗ ) if you pay nothing for the medallion. You would
therefore be willing to pay up to that amount in a daily rental fee for a medallion — which is
indicated as distance R in the graph. This is the equilibrium daily rental fee for medallions.
As a result, those who rent medallions are making zero profit. Those who own medallions and
choose to operate a cab are also making zero profit — because the opportunity cost of using the
medallion to drive a cab is equal to the rental fee R that the owner could have gotten by letting
someone else rent the medallion. Of course, if you are a cab driver, you would still prefer to
own a medallion rather than rent one — but that is because as the owner you get to collect the
equilibrium rent R whether you drive the cab (and don’t have to rent a medallion) or whether
you rent it to someone else.
(e) True or False: The only individuals who would be made worse off if medallions were no longer
required to operate a cab are the owners of medallions.
Answer: This is true. Owners would lose something that has value if medallions are no longer
required. Cab drivers make zero profit with and without the medallion system. Consumers,
of course, are better off without the medallion system where they get to ride around in cabs at
cheaper rates.
(f) Illustrate in your graph the daily deadweight loss from the medallion system. Can you think of a
policy proposal that would make everyone better off?
Answer: Referring to areas labeled in Graph 18.9, consumer surplus in the absence of the
medallion system is (a + b + c). This shrinks to just area a under the medallion system — im-
plying that consumers are made worse off by (b + c) under the medallion system. Owners of
medallions earn rents equal to area b under medallion system — which is surplus to them.
Thus, only area c is lost — and thus becomes the deadweight loss under the medallion system.
Any policy that makes everyone better off would have to compensate owners of medallions for
the loss of the value of their medallions. For instance, the city could buy back all the medallions
at a price equal to the present discounted value of all the income that the owners could have
made from the medallions. Since this is less than the present discounted value of additional
consumer surplus, this would be a deal that would create more benefit than cost for the city —
so long as the city can find a way of raising the money to buy off the owners of medallions in a
relatively non-distortionary way.
18.13 Policy Application: Kidney Markets: A large number of patients who suffer from degenerative kid-
ney disease ultimately require a new kidney in order to survive. Healthy individuals have two kidneys but
usually can live a normal life with just a single kidney. Thus, kidneys lend themselves to “live donations”
— i.e. unlike an organ like the heart, the donor can donate the organ while alive (and live a healthy life
with a high degree of likelihood). It is generally not permitted for healthy individuals to sell a kidney —
kidney’s can only be donated for free (with only the medical cost of the kidney transplant covered by the
recipient or his insurance). In effect, this amounts to a price ceiling of zero for kidneys in the market for
kidneys.
Consider, then, the supply and demand for kidneys.
(a) Illustrate the demand and supply curves in a graph with kidneys on the horizontal axis and the
price of kidneys on the vertical. Given that there are some that in fact donate a kidney for free,
make sure your graph reflects this.
Answer: This is done in Graph 18.10 where the supply curve has to contain a flat spot on the
horizontal axis in order to account for the fact that some give one of their kidneys away for free.
Graph 18.10: Kidney Market
(b) Illustrate how the prohibition of kidney sales results in a “shortage” of kidneys.
Answer: In the graph, the quantity of kidneys supplied at a price of zero is x S while the quantity
demanded at that price is x D . The difference is the shortage.
(c) In what sense would permitting the sale of kidneys eliminate this shortage? Does this imply that
no one would die from degenerative kidney disease?
Answer: If the equilibrium price p ∗ were to be permitted to ration kidneys in this market, the
quantity demanded at that price would equal the quantity supplied at that price. In this sense,
there is no shortage. However, this does not imply that no one would die from kidney failure —
as those not willing (or able) to pay the equilibrium price would still not get kidneys.
(d) Suppose everyone has the same tastes but people differ in terms of their ability to generate in-
come. What would this imply about how individuals of different income levels line up along the
kidney supply curve in your graph? What does it imply in terms of who will sell kidneys?
Answer: If everyone has the same tastes, then the income of kidney “suppliers” increases along
the supply curve as we move to the left; i.e. poorer individuals would be willing to accept lower
prices for one of their kidneys than richer people.
(e) How would patients who need a kidney line up along the demand curve relative to their income?
Who would not get kidneys in equilibrium?
Answer: If tastes were again the same, higher income patients would be willing to pay more
than lower income patients — thus lower income patients would be more likely not to get a
kidney than higher income patients.
(f) Illustrate in your graph the lowest that deadweight loss from prohibiting kidney sales might be
assuming that demand curves can be used to approximate marginal willingness to pay. (Hint:
The lowest possible deadweight loss occurs if those who receive donated kidneys under the price
ceiling are also those that are willing to pay the most.)
Answer: This is illustrated as the area (c + d ). This is because, under the price ceiling, only x S
kidneys are donated. If they are donated to those willing to pay the most, total surplus is (a +b).
If the equilibrium price p ∗ rationed kidneys in the market, the number of kidneys transplanted
would rise to x ∗ — giving total surplus of (a +b +c +d ). We lose (c +d ) by prohibiting the selling
of kidneys.
(g) Does the fact that kidneys might be primarily sold by the poor (and disproportionately bought by
well-off patients) change anything about our conclusion that imposing a price ceiling of zero in
the kidney market is inefficient?
Answer: No, it does not. By prohibiting sales that make both seller and buyer better off, we are
prohibiting mutually beneficial trades from occurring — which is the source of the inefficiency.
The fact that sellers might be relatively poor does not take away from the fact that they value
their kidney less than they value the compensation the receive. And the fact that the kidneys
might be disproportionately bought by the rich does not take away from the fact that they value
the kidneys they buy more than the amount they pay for it — and more than sellers value the
kidneys they are selling.
(h) In the absence of ethical considerations that we are not modeling, should anyone object to a
change in policy that permits kidney sales? Why do you think that opposition to kidney sales is
so wide-spread?
Answer: In principle, it is difficult to rationalize objections to permitting kidney sales in the
absence of ethical considerations. To the extent that live kidney donations occur in the absence
of kidney markets, these donations are typically among relatives who would likely still donate
to their loved ones if kidney markets operated. (To the extent that kidney donations come
from donors who have died, this is not the case — and some who would receive kidneys in
this way may not be able to afford to buy a kidney if such kidneys could be sold). In principle,
there may be some who lose in the transition to a market for kidneys — but the increase in
the number of kidneys would likely lead to a large increase in the number of lives saved. Still,
there are many reasons why one might object to permitting kidney sales — even though this
would save many lives. Some might be concerned that some low income patients who might
have received a kidney under the current system might not have the same chance in a kidney
market. Others might be concerned that individuals who sell their kidneys might not always
make such decisions in a rational state of mind. Yet others might point to potential abuses —
with those in hierarchical power relationships able to coerce participation in kidney markets.
(i) Some people might be willing to sell organs — like their heart — that they cannot live without in
order to provide financially for loved ones even if it means that the seller will die as a result. As-
suming that everyone is purely rational, would our analysis of deadweight loss from prohibiting
such sales be any different? I think opposition to permitting such trade of vital organs is essen-
tially universal. Might the reason for this also, in a less extreme way, be part of the reason we
generally prohibit trade in kidneys?
Answer: In principle, the analysis would be no different at all. To the extent to which there are
potential sellers of their heart who would value the compensation their heirs receive more than
they value their life, we are prohibiting trades that are mutually beneficial — and are therefore
eliminating social surplus that could be generated. The natural opposition to the operation
of such markets is founded in large part on the fact that those who might participate in such
markets are likely to not be fully “rational” in the sense that their motives might emerge from
psychological difficulties. Those contemplating suicide, for instance, would be natural candi-
dates for sellers in this market, and we generally do not consider suicide as a rational act. In a
less extreme way, concerns over the psychological issues that might lead one to participate in
kidney markets may also play a role in the general opposition to permitting such markets.
18.14 Policy Application: Oil Shocks and Gasoline Prices: In 1973, the OPEC countries sharply reduced
the supply of oil in the world market — raising the price of oil and thus the marginal cost of producing
gasoline in domestic refineries. In 2008, uncertainties over the stability of oil supplies and increasing
demand from developing countries (as well as from oil speculators) also caused sharp increases in the price
of oil — again dramatically increasing the marginal cost of producing gasoline in domestic refineries.
While the causes of higher oil prices differed, the impact on domestic gasoline refineries was similar. Yet
in 1973, vast gasoline shortages emerged, leading cars to line up for miles at gasoline stations and causing
governments to ration gasoline — but in 2008 no such shortages emerged. In this exercise, we explore the
difference between these experiences.
The difference is attributable to the following policy intervention used in 1973: In 1973, the government
imposed price controls — i.e. price ceilings — in order to combat inflationary pressures, but in 2008 the
government did no such thing.
(a) Consider first the experience of 1973. Begin by drawing the equilibrium in the gasoline market
prior to the oil shock.
Answer: This is done in panel (a) of Graph 18.11 where the initial supply curve is S and the
initial equilibrium price is p ∗ .
Graph 18.11: 1973 vs. 2008
(b) Now illustrate the impact of the OPEC countries’ actions on the domestic gasoline market.
Answer: The increase in the price of oil resulting from the actions of OPEC caused an increase
in the marginal cost of producing gasoline — which in turn shifted the supply curve for gasoline
from S to S ′ . In the absence of any government interference, this would lead to an increase in
the price of gasoline from p ∗ to p ′ .
(c) As gasoline prices began to rise, the government put in place a price ceiling between the pre-crisis
price and the price that would have emerged had the government not interfered. Illustrate this
price ceiling in your graph.
Answer: This is also illustrated in panel (a) of Graph 18.11 where p represents the government
imposed price ceiling. This would make no difference had there been no shift in supply —
because the original equilibrium price p ∗ fell below p. But after the shift in supply, the price
ceiling binds in the sense that it falls below what would otherwise be the equilibrium price p ′ .
(d) If we take into account the cost of time spent in gasoline lines, what was the effective price of
gasoline that consumers faced?
Answer: In the presence of the price ceiling, consumers have to spend additional effort procur-
ing gasoline, in our case by waiting in line. The point A in panel (a) of Graph 18.11 does not
become a new equilibrium until the equilibrium effort cost on the part of consumers is suffi-
cient to push demand down such that it intersects S ′ at A. This requires a cost of waiting in line
equal to (p ′′ − p) — implying that the effective price, which includes both the dollar price plus
the cost of waiting, rose to p ′′ .
(e) Now consider 2008 when the government did not impose a price ceiling as gasoline prices nearly
quadrupled over a short period. Illustrate the change in equilibrium — and the reason no short-
age emerged.
Answer: This is illustrated in panel (b) of Graph 18.11 where the shift in supply simply moves
us from the original equilibrium B to the new equilibrium C — with price increasing from p ∗
to p ′ .
(f) Suppose that the 1973 and 2008 shocks to the marginal costs of refineries were identical as were
initial supply and demand curves. If we take into account the cost of waiting in lines for gasoline
in 1973, in which year did the real price of gasoline faced by consumers rise more?
Answer The real cost faced by consumers in 1973 was p ′′ while the real cost faced by consumers
in 2008 was p ′ . Since p ′′ > p ′ , the real cost to consumers was higher in 1973 than in 2008 despite
the fact that the government actively tried to keep prices down in 1973 but not in 2008.
(g) When the government compiles statistics on inflation,in which year would it have shown a larger
jump in inflation due to the increase in the price of gasoline?
Answer: When compiling statistics on inflation, the government would not include the cost of
waiting in line, only the cash prices. The cash price of gasoline rose to p in 1973 and to p ′ in
2008. Since p ′ > p, government statistics on inflation due to the price of gasoline would show
a greater increase in 2008 than in 1973 (even though the real cost to consumers rose more in
1973 than in 2008).

Elasticities, Price Distorting Policies and Non-Price Rationing

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Elasticities, Price Distorting Policies and Non-Price Rationing

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Solutions for Microeconomics: An Intuitive

They may not be made publicly available.

Reproduction and/or distribution of the solutions beyond classroom use is

In most colleges, it is a violation of the student honor code for a student to

• Each end-of-chapter exercise begins on a new page. This is to facilitate max-

Graph 18.1: Price Elasticity as we Approach the Axes

Graph 18.2: Coffee Price Ceiling

Graph 18.3: Basketball Tickets

Graph 18.4: Minimum Wage Laws

Graph 18.5: Usury Laws and Elasticities

Graph 18.6: Price Floor in Corn Market

Graph 18.7: Corn Subsidies through Price Floors (cont)

Thus, the deadweight loss is again (h + i ).

Graph 18.8: Rent Controlled Apartments

Graph 18.9: Taxi Cab Medallions

Graph 18.10: Kidney Market

Graph 18.11: 1973 vs. 2008

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